On May 18, 2016, the SEC released new guidance regarding the use of non-GAAP measures in the form of twelve new or updated Compliance and Disclosure Interpretations (C&DIs).1 This new guidance comes on the heels of several critical comments from SEC Chairman Mary Jo White and other SEC officials on the increased use and potentially misleading nature of such measures.2
The C&DIs address Regulation G, which concerns all public disclosures of information that contains non-GAAP financial measures made by 1934 Act registrants and Item 10(e), which regulates the use of non-GAAP financial measures in filings made under the 1933 or 1934 Acts. Collectively, the new C&DIs suggest that there will be increased scrutiny on the usage and types of non-GAAP disclosures by the SEC staff.
The new guidance addresses how certain non-GAAP measures can be potentially misleading under Rule 100(b) of Regulation to operate a registrant’s business could be misleading.3 Additionally, the staff clarifies that a non-GAAP measure can be misleading if it is presented inconsistently between periods.4 Also, a non-GAAP measure that is adjustedG. In particular, the staff notes that certain adjustments, although not explicitly prohibited, could cause the non-GAAP measure to be misleading. For example, the presentation of a performance measure that excludes normal, recurring, cash operating expenses necessary only for non-recurring charges when there were non-recurring gains that occurred during the same period, could potentially violate Regulation G.5 Lastly, the C&DIs address a hypothetical situation in which a company presents a non- GAAP performance measure that is adjusted to accelerate revenue recognized ratably over time in accordance with GAAP as though it earned revenue when customers were billed. The staff notes that non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for GAAP measures could violate Rule 100(b) of Regulation G, and further, that other measures that use individually tailored recognition and measurement methods for financial statement line items other than revenue may also violate Rule 100(b).6
The C&DIs also clarify whether certain non- GAAP measures may be presented on a per share basis pursuant to Item 10(e). The staff notes that non-GAAP liquidity measures that measure cash generated must not be presented on a per share basis in documents filed or furnished with the SEC. Whether per share data is prohibited depends on whether the non-GAAP measure can be used as a liquidity measure, even if management presents it solely as a performance measure. Going forward, the staff is expected to focus on the substance of the non-GAAP measure and not management’s characterization of such measure when analyzing such disclosure.7 The staff also notes that free cash flow (e.g. cash flows from operating activities less capital expenditures) is a liquidity measure that must not be presented on a per share basis and EBIT and EBITDA (along with similar measures) must not be presented on a per share basis.8
The new guidance also mandates equal prominence between non-GAAP measures and the corresponding GAAP measurements under Item 10(e)(1)(i), setting forth the staff’s view that GAAP measures must be presented first and described narratively in a manner similar to that of the comparable non-GAAP measures. The guidance will effect, among other things, disclosures made in annual and quarterly reports and earnings releases. The staff notes in particular that a company is prohibited from:
- Presenting a full income statement of non- GAAP measures or presenting a full non- GAAP income statement when reconciling non-GAAP measures to the most directly comparable GAAP measures
- Omitting comparable GAAP measures from an earnings release headline or caption that includes non-GAAP measures
- Presenting a non-GAAP measure using a style of presentation (e.g., bold, larger font) that emphasizes the non-GAAP measure over the comparable GAAP measure
- A non-GAAP measure that precedes the most directly comparable GAAP measure (including in an earnings release headline or caption)
- Describing a non-GAAP measure as, for example, “record performance” or “exceptional” without at least an equally prominent descriptive characterization of the comparable GAAP measure
- Providing tabular disclosure of non-GAAP financial measures without preceding it with an equally prominent tabular disclosure of the comparable GAAP measures or including the comparable GAAP measures in the same table
- Excluding a quantitative reconciliation with respect to a forward-looking non-GAAP measure in reliance on the “unreasonable efforts” exception in Item 10(e)(1)(i)(B) without disclosing that fact and identifying the information that is unavailable and its probable significance in a location of equal or greater prominence
- Providing discussion and analysis of a non- GAAP measure without a similar discussion and analysis of the comparable GAAP measure in a location with equal or greater prominence.9
Lastly, the staff clarifies that registrants should provide income tax effects on their non-GAAP measures depending on the nature of such measures. If a measure is a liquidity measure that includes income taxes, the guidance suggests that it might be acceptable to adjust GAAP taxes to show taxes paid in cash. If a measure is a performance measure, the staff notes that companies should include current and deferred income tax expense commensurate with the non-GAAP measure of profitability. In addition, adjustments to arrive at a non-GAAP measure should not be presented “net of tax.” Rather, income taxes should be shown as a separate adjustment and clearly explained.10
These C&DIs make clear that the SEC will be taking a more aggressive approach in reviewing a company’s use of non-GAAP measures, and we can expect to see more staff comment letters in the coming months. Companies should review their current disclosure practices in light of this new guidance.